INDEPENDENT SYSTEM OPERATORS(VI + Access Rules vs. ISO vs. ITSO)

Paul L. Joskow

September 28, 2007

ALTERNATIVE SYSTEM OPERATOR MODELS

• System operator (SO) is vertically integrated utility (G+T)– Functional separation of SO and TO from generation, marketing

and distribution combined with information transfer rules– Transparent “unbiased” open access terms and conditions (tariff

conditions) for transmission network interconnection, delivery, ancillary services, balancing

– Transparent “unbiased” system operating protocols for scheduling dispatch, congestion management, and emergencies

– Open transparent “unbiased” transmission planning process– Operate and plan the transmission network as if there is no

vertical integration– Typically implemented with a (physical and financial) bilateral

contract system plus cost-based ancillary services and balancing– Regulator (and network users) responsible for monitoring

violations of SO and TO access rules and general market monitoring and market power mitigation

– Example: Vertically integrated utilities in the U.S. operating under FERC Orders 888/889/890 and related interconnection and functional separation orders

ALTERNATIVE SYSTEM OPERATOR MODELS

• Transco (ITSO) Model– Ownership separation of TO/SO from generation, marketing,

retail supply to eliminate potential conflicts of interest– SO and TO functions are under common ownership/control– SO/TO are regulated (ideally with PBR)– SO/TO may be privately-owned or state-owned though

ownership affects incentives and behavior– Corporate governance arrangements consistent with

independence from affiliated market participants– Transparent network access, operating rules, pricing and

investment planning (regulated tariff rules and terms)– Horizontal integration of transmission facilities to create large

enough SO/TO to span regional market areas– Typically combined with transparent organized public markets for

energy, network support services and congestion management that are used by the ITSO to fulfill responsibilities

– Examples: National Grid in England and Wales, Red Electrica in Spain, TenneT in the Netherlands (almost)

ALTERNATIVE SYSTEM OPERATOR MODELS

• Separate ISO without ownership of T or G– Independent of all market participants, transmission and distribution

owners – owns control room and communications facilities– Responsible for all aspects of reliable and economical system

operations and interconnection and may cover facilities of multiple transmission network owners (some vertically integrated)

– Independent board of directors: Private, state-owned, not-for-profit– Stakeholder committees to review procedures and comment on them– Transparent open access network rules, prices and operating

protocols (regulated tariff)– Wide variations in “depth” of ISO functions but a trend toward deeper

functional responsibility over time– Increasing responsibility for integrated planning of transmission

investments– Typically integrated with operation of organized wholesale markets

for energy, frequency requlation and operating reserves, balancing that it uses to operate the network (scheduling, dispatch, congestion management, etc.) economically and reliably

– Examples: PJM, ISO-New England, AESO in Alberta, National Grid in Scotland

Source: State of the Markets Report 2004, FERC Office of Market Oversight andInvestigations (2005, page 53).

ISO/RTOs in the United States 2006

ISO NENYISO

PJM

MISO

ERCOT

SPPCAISO

970,000Total U.S. Generating Capacity

_______

552,000ISO/RTO Total

_______

60,000Southwest Power Pool (RTO)[1]

78,000ERCOT (Texas)

52,000California ISO

130,000Midwest ISO (MISO)

164,000PJM (expanded) (RTO)

37,000New York ISO

31,000ISO-New England (RTO)

Generating Capacity(MW)

System Operator

Independent System Operators and Organized Wholesale Markets 2006

[1] Organized markets being developed

BASIC ATTRIBUTES OF U.S. ISOs• Independent System Operator (ISO)

– Non-profit entity (effectively) that does not own transmission assets– Independent boards plus stakeholder committees– Responsible for operating the network reliably and economically– Manages FERC Open Access Transmission Tariff, OASIS,

generator interconnection rules– Manages voluntary wholesale spot markets for energy and ancillary

services– Manages requests for transmission service, allocation of scarce

transmission capacity and network expansions– Transparent Regional Transmission Expansion Planning process– Market monitoring and mitigation programs– Coordination with neighboring control areas, including

imports/exports (cross-border trade)• Regulated Incumbent Transmission Owners (TOs)

– Functional separation rules if TO is vertically integrated– T Maintenance in conjunction with ISO– Opportunities/obligations for new regulated and merchant T

projects– Regulated projects must go through ISO planning process

ISOs OPERATE AND USE WHOLESALE MARKETS FOR OPERATIONS

• Security constrained bid-based dispatch using state-estimator network model– Day-ahead hourly markets – Real-time market (adjustments, imbalances, 5-

minutes)– Self-scheduling permitted subject to imbalance and

congestions charges• Resulting LMPs calculated at each bus

– Marginal cost of congestion– Marginal cost of losses (NE, NY, and now PJM)– Internalizes network externalities into prices– Allocates scarce transmission capacity efficiently

• Market-based provision of frequency regulation and operating reserves integrated with day-ahead and real-time energy markets

ISO OPERATE GENERATING CAPACITY MARKETS

• Generating capacity (reserve) obligations imposed on retail suppliers (e.g. 18% forward reserve margin) and/or “capacity markets” and capacity payments– New England and PJM– “Reserve Capacity demand curve” in New York– California will have capacity obligation/payment system– MISO considering capacity obligation/payment system– Texas will continue to rely on “energy only” markets

Source: FERC 2006 State of the Markets Report

ISO NEW ENGLAND MARKET PRICE COMPONENTS

ISO-NE (2007)

ISO-NE (2007)

ISO-NE (2007)

MARKET MONITORING AND MITIGATION• Independent market monitor (big fuss in PJM at

the moment)• $1000/MWh general bid cap on spot energy and

capacity markets (lower in CA and higher in Texas)

• Local market power mitigation rules– Bid caps– RMR contracts for load pockets– Must-offer requirements– Interaction with computation of market prices

• Ex-post bid/price adjustments• Monitoring of individual market participant

behavior and market performance

Transmission lines230-500 kV

Networkswitchyard

Transmission subs

66-115 kV lines

Distribution subs

Distribution lines

GeneratorStep-up

State: bundled VI genFERC: unbundled gen

State: Bundled “retail” T + sitingFERC: Unbundled “wholesale” T

Entirely State

HOW DO TRANSMISSION OWNERSGET PAID

WITH SEPARATE ISO?

FERC TRANSMISSION REGULATION

• Transmission service (“wheeling”) charges– Network service charges – Integration of individual TO tariffs has evolved

• No “pancaking” of transmission charges to generators and marketers within an ISO

• Pricing to shippers initially based on TO’s costs at point of entry• Pricing to distribution companies initially based on TO costs at delivery

destinations• Evolving to rolled-in “postage stamp” pricing with reallocation of revenues

based on transmission cost shares– Physical and financial firm transmission rights to hedge congestion and

support investment– Nodal pricing and congestion charges in organized ISO/RTO markets

• Interconnection charges for generators and merchant transmissionprojects– Shallow– Deep

FERC TRANSMISSION SERVICE PRICING FOR TOs

• FERC applies traditional embedded cost of service pricing to each TO under ISO– Roll-in cost of all transmission assets > 69kv at original cost less ∑depreciation to form “rate base”

– Apply ROR and depreciation rate to rate base to get target allowed annual capital service revenues

– Pro-forma debt/equity ratio assumed– Add operating costs– Develop price per/Mw of network transmission service– Long periods of regulatory lag without “true-up”– No performance benchmarking or performance incentives ---

FERC does not even collect performance data that could be used to structure a PBR system

– “Postage stamp” pricing based on share of network peak demand

FERC TRANSMISSION PRICING

• 2005 Energy Policy Act required FERC to develop incentives to promote transmission investment to ensure reliability and reduce wholesale power costs by reducing network congestion

• FERC has responded by offering higher “incentive” ROE for new (FERC jurisdictional) transmission investments and for joining an “independent” transmission entity

• FERC has not applied real PBR regulation aside from that implicit in regulatory lag

• The development of incentives by FERC has been confused and controversial

GENERATOR INTERCONNECTION POLICIES

• Transmission owners must build interconnection facilities for new generators and offer them transmission service on the network consistent with reliability standards

• “Shallow” interconnection costs charged to generators requesting service

• “Deep” interconnection costs are initially charged to generator causing the need for “deep” upgrades to meet reliability standards.

• But these costs are gradually rolled into general network tariff and rebated to generators over time– PJM has a different system which allocates these costs to the

generator(s) causing them and gives them FTRs in return.

TRANSMISSION CONSTRUCTION PERMITS

• Primary responsibility is with the states• FERC has “backstop” siting/permit authority for certain

critical transmission corridors• This is quite different from natural gas pipelines where

FERC has most of the construction/siting authority• In ISO/RTO areas, the ISO/RTO does system-wide

transmission planning and designated transmission upgrades to be built by the affected transmission network owner

• In other areas the individual states have transmission planning authority– State incentives are protectionist and distorted

STRENGTHS AND WEAKNESSES

• Functional separation of VI utilities plus regulated open access tariff conditions– Politically convenient– Ultimately any benefits of vertical integration are lost– Functional separation and information transfer restrictions (2003

Northeast Blackout)– Potential benefits of horizontal integration of TOs are not

realized– Continued litigation over self-dealing and vertical market power

problems– Contest between political power of incumbents and power of

regulator and competition authorities– Requires strong regulator and competition authority– Functional separation evolves toward a crippled ISO– Ultimately incompatible with liberalized wholesale and retail

markets with good performance attributes

STRENGTHS AND WEAKNESSES• Separate ISO

– Politically more acceptable compared to Transco (ITSO)– The devil is in the details– ISOs with “deep functional” responsibilities that are well integrated

with wholesale markets work reasonably well– Inefficiencies from absence of vertical integration with TO functions

• Efficient coordination of maintenance and investment planning can be challenging

• Interconnection process is cumbersome– Effective governance and regulation of ISO are also challenging,

especially if not-for-profit• What are the incentives ?• Soft budget constraints if not-for-profit• Stakeholder process is cumbersome• Good PBR regulation is more difficult

– The responsibilities of the ISO tend to expand over time to dealwith these inefficiencies

• TOs become passive owners of regulated assets that march to the ISOs orders

STRENGTHS AND WEAKNESSES

• Transco– The ideal model in theory– Independence is structural– Focused business model– For-profit Transco is easier to regulate with PBR

since objectives and incentives are clear– Requires well developed PBR regulatory mechanisms– Some functional separation required if there are

unregulated lines of business (e.g. interconnections)– Restructuring to create regional Transco is very

challenging politically– Existing Transco’s have exhibited good performance

in all dimensions

DESIGN ISSUES FOR SEPARATE ISOs

• Geographic scope• Functions• Ownership form and Governance structure• Mandatory or Voluntary TO membership• Regulatory authority and PBR mechanisms• Integration with wholesale markets for energy,

operating reserves, and emergency protocols• Network expansion planning responsibilities• Integration with responsibilities and regulation of

TOs